Six years ago, I wrote a post that reflected my view of the proper relationship between the Fed and the markets:

That’s not Bullard’s job. He hasn’t been hired to outguess the markets. If he wants to do that he should go run a hedge fund. His job is to be led around by the markets like a stupid ox with a steel nose ring being dragged along by a farmer.

Congratulations, Market. The Fed Is Officially at Your Mercy.

So am I ready to declare victory for market monetarism? Not quite. We still need a NGDP market. TIPS spreads and stock market indices are better than nothing, but there’s no substitute for a NGDP futures market.

But we are making real progress. The Fed is not using macro “models” to set interest rates.

Yes, I see no alternative better than something like an NGDP futures market. While the degree to which NGDP and the risk-free rate might reveal the stance of monetary policy in hindsight, the data is too noisy to be forward-looking.

That is, unless we consider some of George Selgin’s free banking ideas, which seem compelling. What’s New Zealand up to these days?

Is the Fed following markets or is the Fed leading markets? Powell’s turnaround seems motivated by falling asset prices, and his objective to stop it and return to the status quo ante (rising asset prices). If Powell were following markets, he would let asset prices fall since that’s the direction markets were taking asset prices. It seems that Powell is afraid of markets, at least markets with falling asset prices. Falling asset prices could be markets correcting too high asset prices. Stopping the fall in asset prices prevents markets from working their magic; indeed, by preventing asset prices from falling naturally, it sets up a descent from a much higher point, possibly resulting in a faster and further descent than if asset prices were allowed to fall naturally (i.e., by markets). Does Sumner speak the language of markets? Maybe my problem is that I don’t understand the language.

Agree that it seemed Powell was doing the right thing, paying attention to “financial market conditions”. But 10 year bond yields should really have risen, not fallen if he was easing. And they are still falling today. It’s puzzling. They were falling before the meeting too. Is the Fed behind the curve? Should it have gone further than merely pausing it’s rate rises?

I don’t believe Powell was concerned about NGDP expectations, he was concerned about falling asset prices. Now one might lead to the other, but if one believes in markets, one would allow asset prices to rise or fall as markets determine. I know, Sumner is a believer in markets; otherwise, why would he promote a futures market in NGDP to determine monetary policy. My response: there isn’t an NGDP futures market to determine monetary policy today.

Some people seem to think it’s bad that Powell “capitulated”, as though a Fed chairman’s job is to stare down markets and cause horrible disasters like Bernanke did. Powell should be praised for backing down, that’s his job. Short of putting someone who really “gets it” at the Fed, we’re better off with a non-economist like Powell, who will back down in the face of market protest, as he has no deep commitment to any theory. Powell was not my favorite person about a month ago, but he’s redeeming himself.

As for Trump potentially putting “unqualified” Herman Cain on the FOMC, I say do it! Being qualified is no substitute for being dovish. Onward and upward to 6% NGDP growth! Throw the debt-laden millenials a bone.

Generally, in the face of Knightian uncertainty about what drives specific asset price moves, it is better to pursue moderate outcomes rather than extreme outcomes – which means responding to market signals rather than dogmatic pursuit of models and theory. Clearly markets were extremely worried about something, and that probably deserves a cautious response rather than proceeding into a possible asset price led recession out of some misguided “principles”.

What is dangerous about using asset markets (particularly equities) as a noisy signal however, is that they have embedded in them a lot of real rather than nominal profit stream expectations, information about the expected long run split of aggregate income between labour and capital and also risk premia, which are in some cases only weakly correlated to variables the central bank can in fact control in the long run. A lot of the literature suggests the most volatile component of price is in fact the risk premium element, rather than profit expectations.

If it turned out to be that the transition through the initial market wobble in October (“long way from neutral”) to the nadir in December was really about the loss of central bank activism in asset prices, rather than any particularly strong change of view by the market on the nominal income outlook – re-establishing activism is in fact on some level underwriting moral hazard and interfering in price formation of the risk premium itself. The markets may cheer it now, but this is only because current asset holders are the beneficiaries of declining risk premia. Inevitably suppressed risk premium will require more and more intervention in future.

In the long run, this has distributive effects, by indirectly intervening in asset markets, private sector risk premia fall, which probably transfers wealth from young (the asset acquirers) to old (the asset divesters) as assets move through generations at higher prices as well as the broad population to the asset-rich as common resources get diverted to propping up risk premium.

I think any argument against the Fed backing off would have to be based on the fact that the backing off seems to be made necessary in no small part by US policy risks on trade, etc. So there is an argument that the Fed’s responsiveness enables bad policy decisions (as defined by the market’s reaction). This could introduce problematic source of noise; if the market assumes that the Fed will mitigate bad policy, then the market will not price in its assessment of bad policy.

So maybe the Fed was fully optimal over the past few months, letting the market think that policy would not adjust in order to force the market to come up with a ceteris paribus pricing of the policy risks. Gotta make ’em sweat a little bit.

@derek, yeah, it’s an eternal two-way dialogue. The Fed is reacting to the market and the market is trying to guess what the Fed will do. Sometimes it seems like the market is operating on a bit too much caffeine. Not surprising considering it is riven with an ever-changing mix of fear and greed.

Derek, That’s the circularity problem, which is why it would be better to have an entirely different regime, where the markets directed the tools of policy.

Leave a Reply

Name (required)

Mail (will not be published) (required)

Website

Search

About

Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.